by: Matthew Webster – January 29th, 2019
For the past two years, the free agency buzz has circulated around two names: Bryce Harper and Manny Machado. (Matthew de Marte and Matt Carlin previously covered Harper and Machado’s potential landing spots and contract terms here and here.) Last off-season, teams were cutting payroll and dipping under the luxury tax in order to get “a little bit stupid” in 2019, as stated so beautifully by Phillies owner John Middleton. Yet here we are again, with both generational free agents still on the market at the end of January. When free agency began, people speculated whether Machado would take less money to join the Yankees or if Harper would save the Nationals some money with a hometown discount. Yet, it is abundantly clear now that these players want to get paid and the highest bidder should win the sweepstakes. It seems teams have no way to differentiate themselves other than opening up the wallet more.
In Finance 101, the first lesson we learn in the introductory class is the time value of money and how to calculate the present value of future cash flows. According to financial and economic theory, a dollar today is worth more than a dollar tomorrow because that dollar can be invested and earn interest. Let’s look at a simple example. If I have $100 today and can earn 6% this year, I would have $106 at the end of the year. I would rather have the $100 now than in a year because I can make an extra $6! That’s an overpriced hot dog at the ballpark, and I am all for that. For the purposes of this article, we want to consider the other direction. If someone offers me $106 in a year, I want to find out how much that is worth to me today. Using that same 6% as the “discount rate,” I discount the future cash into present value using the formula below and see it is indeed worth $100 today.
Present value calculations are used to value a wide range of financial tools, including annuities. Annuities are a series of payments, not necessarily of equal value, that are paid in equal intervals in the future. Sound familiar? Naturally, that is where my mind goes during class. When thinking about Harper and Machado, I became increasingly curious about the effects of changing the amount and timing of salary payments on the present value of their contracts. Maybe a team has to pay more to get Harper or Machado, but can they allocate that money in a more optimal way?
In order to best understand the impact of changing the timing and amount of salary payments, I analyzed one of the most interesting baseball contracts in terms of financial structure: Max Scherzer’s 7 year, $210MM contract with the Nationals signed prior to the 2015 season. On paper, Scherzer has an average annual value (AAV) of $30MM over those 7 years. However, in terms of cash flow, Scherzer is being paid $15MM a year for the next 14 years! How is this possible? Scherzer’s 2019, 2020, and 2021 salaries of $35MM a year were deferred without interest, to be paid in annual installments of $15MM a year from 2022 through 2028. After digging into Max Scherzer’s unique contract structure with the Nationals, I believe teams could convince Harper and/or Machado to sign by increasing their total offers and including significant deferred payments after the end of their playing time.
In the financial analysis, we’ll focus on Manny Machado. Despite deferred contracts being uncommon across the league, the Nationals have recently become the only team that consistently offers deferments in their deals (Corbin, Scherzer, Strasburg, Murphy, Wieters, etc.). If Harper ends up returning to the Nats, it will most likely be with some deferred payment. Thus, the deferments would be more of a departure from normal contract negotiations for the teams that could sign Machado (White Sox, Phillies, Yankees, [insert mystery team here]).
I used the 9 year, $301MM projection from the SOTG Free Agent model for Machado’s baseline contract projection. For the deferred contracts, I used Max Scherzer’s structure of flat salaries during the playing years and paying the deferred money over the same length as the regular salary (Machado would receive all of his payments after 18 years). I ran a sensitivity analysis using 5%, 6%, and 7% discount rates to calculate the net present value of the contracts, and compared the baseline deal (backloaded structure) with 50% deferred, 25% deferred, and 17% deferred deals. Because of the time value of money, the deferred contracts have a higher total value than a normal 9 year deal. As we showed before, Machado wouldn’t want $301MM over 18 years if he could get $301MM over 9! I assumed a team would offer Machado a $327MM deal, as this would both give him the highest AAV ($36.3MM a year versus Greinke’s $34.4MM) and highest total value of any contract, besting Giancarlo Stanton’s $325MM deal.
VISUALIZING THE DATA
For team ownership, the more deferred money the better. Lower salaries during the life of the deal mean they can earn a return now by signing other players, investing in research and development, upgrading the hot dog stands, etc. The 50% deferred and 25% deferred deals make the most sense for the team, as the present value of the 17% deferred contract is higher than the backloaded deal at each discount rate.
For Machado, the 17% deferred contract offers the greatest net present value of the four deals, yet he would most likely not be offered this deal by a team. The 50% deferred contract has a net present value far below the backloaded contract, thus it seems Machado would not accept this type of deal. This leaves the backloaded deal and the 25% deferred contract as the remaining two possibilities.
According to the charts above, the backloaded and 25% deferred deal have the same net present value of $221.6M at a 6% discount rate. Therefore, Machado and the team would be indifferent between both contracts. The present value of the deferred deal is slightly above the backloaded deal at 5% and slightly below at 7%. However, for Machado, the deferred contract offers something a normal backloaded deal does not: guaranteed money for an extra 9 years. Machado would play out this contract through his age 35 season. Assuming Machado plays until he is 40, the deferred deal would pay him $49MM on top of whatever he earns playing from age 36-40 and $35MM after retirement. All of this is guaranteed. This could be a huge selling point, and the differentiating factor that convinces Manny Machado to put pen to paper.
If a team wants to land Manny Machado, based on our model and financial projections they should offer him a 9 year, $327MM, 25% deferred contract. This unique structure would all but guarantee being the highest offer and would land a generational talent without offering much more if anything in additional net present value. For Machado and agent Dan Lozano, they get to say they signed the biggest contract in history both in total value and AAV. Manny gets paid, and the team gets an absolute stud on the left side of the infield.
All reports this offseason suggest neither Manny Machado nor Bryce Harper will eclipse the $300MM threshold. I think it is more prudent to use the above information to look at the potential popularization of deferred contracts in signing free agents rather than the actual numbers. The Nationals have made the deferred contract commonplace in their contract negotiations, especially when signing big time free agents they were not favored to land. It is entirely possible the deciding factor for the players was the financial structure and deferred payment. Hopefully this offseason or sometime in the near future, an owner or a GM (not from the Nationals) will make a splash in free agency by offering a deferred contract and making this structure more commonplace.
We have made the Excel spreadsheet available here, and we encourage you to play around with the numbers to see how everything changes!
Cover Photo courtesy of nj.com